Dividends and the power of compound interest

Over the last decade as interest rates have fallen, dividend-paying stocks have proven why they deserve a place at the heart of all balanced portfolios.

The trend of rate cuts continued this year – and more may be in store.  A third of all global sovereign bonds now yield less than zero, which means that on maturity, you get back less than you paid.  Not much of a deal!

So it is impossible to generate adequate income without a portfolio that includes high quality stocks to offset the diminishing returns of bond holdings.

But how to choose and what to look for?

The fact that a company pays a dividend is a good sign. It says the company is financially stable. If the payments go back far enough it tells you which down drafts the company has weathered. Since the decision to pay a dividend is made at the beginning of the year, before the money has been made,  management’s decision to set it aside means it has confidence in its business.

But while a high dividend yield is often a good sign of quality, it isn’t always and it is not the only reason to buy a  stock. Dividend yield is calculated by dividing a company’s annual dividend payment by its share price and while a high yield means more in your pocket, it can sometimes be a warning.

It may indicate a company’s share price has fallen, which pushes the yield up. The decline in share price may be due to business conditions and signal a sign that investors believe the dividend will be cut. Some recent examples of cuts include Torstar, which publishes the Toronto Star. In October, it suspended its dividend. Mighty General Electric, cut its dividend twice in 2018 and now pays a penny, a quarter. Vodafone, the British telecom giant cut its dividend by 40% in May. All three are going concerns, but all face business challenges and need the cash for their businesses. The yields on their stocks approached double digits before they were cut.

So, it pays to dig a little deeper and keep an eye on things beyond the yield. These include:

• What portion of profits does the company pay out, which is known as its payout ratio;
• How often is the dividend increased;
• By how much on average is it increased;
• How sustainable is the payment if conditions change.

One of my favourite stocks, McDonald’s, (NYSE:MCD), is a dividend and performance champion. McDonald’s ticks all four boxes.

Its payout ratio has been between 48% and 72% for the past decade and is currently at 61%. This means McDonald’s is paying 61% of its profits to shareholders and retaining the rest for investment in its business. Should profits fall, it has a cushion that will allow it to keep paying the dividend.

McDonald’s has increased its dividend in each of the last 10 years by an average of 8.9% a year. If that growth stays the same, it means its dividends will double on average every 8 years. That’s quite a payday.

When it comes to sustainability, McDonald’s has raised its dividend every year for the past 42 years. That means it has done so through every big market event, from the Crash of ’87, through the dotcom collapse in 2000 and the 2008 financial crisis.

CAE, (TSX:CAE) the Montreal-based global flight simulator and pilot training company, is another favourite.

It has a current yield of 1.23% and a payout ratio of 33% based on its trailing 12 months earnings. The payout ratio is much lower than McDonald’s because CAE is a growth stock and reinvests more of its profits back into its business.

On the other hand, CAE’s average annual dividend increases over the last 10 years are better than McDonald’s They have averaged 13.6% a year. That indicates CAE is also unlikely to cut its dividend any time soon.

If you don’t need the income and reinvest the growing stream of dividends through Dividend Reinvestment Plans (DRIPs) your returns are supercharged. That’s because you receive dividends on dividends, a compounding power that Albert Einstein once called the Eighth Wonder of the World.

An analysis by Guinness Atkinson Funds in the UK a  few years ago, suggested that dividends provide between 30% and 40% of investment gains in the short and medium-term.

Guinness Atkinson reviewed the total returns of the 500 companies in the S&P 500 index from 1940 through 2012. It found that for an average holding period of one year, dividends accounted for 27% of total returns. Over 3 years, they accounted for 38% of returns. After 5 years it was 42%.

The  study pointed out that many non-dividend-paying stocks are also excellent performers and there is no one size fits all.

At a recent Mindpath conference for investment advisors, Sri Iyer, Head of Equities for Guardian Capital Group, talked about Guardian’s filtering software which screens for high dividend payers with the highest sustainability factor.

Guardian manages a dividend ETF for Horizon Funds. Among his favourite dividend champs:  McDonald’s, Apple (NDQ:APPL), Costco (NDQ: COST), ADP (NDQ:ADP) and Mastercard (NYSE: MA)

Mr. Iyer rated Canada’s banks and insurance companies as very strong with sustainable payments and singled out the Royal Bank as his top pick.

This doesn’t mean the other banks are bad bets. The Big 5 and their predecessors have a dividend track record that goes back more than 150 years. Bank of Montreal (TSX:BMO) began paying dividends in 1829 and BMO Financial Group is the longest-running dividend-paying company in Canada with to pay out 40% to 50% of its earnings in dividends over time.

The Bank of Nova Scotia (TSX: BNS)  followed in 1832. TD (TSX:TD)  has paid dividends since 1857, the CIBC (TSX:CM) since 1868 and Royal Bank (TSX: RY) since 1870.

The  Guardian Capital model sees a higher probability that European telecoms may cut their dividends as growth slows. Mr. Iyer sees a similar risk for some higher yielding U.S. based mortgage backed securities. That doesn’t mean it will happen.

“A higher probability just means that the risk is growing,” he said.

You might like:  These dividend funds offer diversity

(This article appeared in the Dec. 2, 2019 edition of the Internet Wealth Builder investment newsletter.)